An Introduction to Trading Patterns
The movements of asset prices often form recognisable patterns with fairly predictable outcomes.
The movements of asset prices often form recognisable patterns with fairly predictable outcomes. These patterns form when prices consolidate before either continuing in the direction of the trend or reversing the previous trend.
With a bit of practice, chart patterns are easy to spot, allowing traders to quickly scan lots of charts to identify opportunities. Chart patterns have specific rules regarding trade entry and the levels to use for profit targets and stop losses.
Most patterns either signal a potential continuation or a reversal of the prior trend, however some can lead to both depending on the direction in which they break out. All chart patterns can be bullish or bearish depending on the structure of the pattern and the direction of the prior trend.
The Head and Shoulders is perhaps the most widely known chart pattern. It is also the most recognisable and one of the most reliable patterns to trade. It represents a consolidation that occurs at market tops after prices have risen and is therefore a bearish pattern.
Head and Shoulders Pattern
After forming a higher high, the price falls all the way back to where that high began. It then makes a lower high and falls back to the same level, forming a neckline and completing the pattern. A short trade is triggered when the neckline is broken. The target is the height of the head (the middle peak) and the pattern fails if the high of the right shoulder is breached.
An upside down, or inverse head and shoulders is a bullish pattern that occurs after prices have fallen.
Other reversal patterns include:
- Double tops (bearish) and double bottoms (bullish)
- Triple tops (bearish) and triple bottoms (bullish)
- Rising wedges (bearish) and falling wedges (bullish)
- Rounded bottoms (bullish)
- Cup and Handles (bullish)
The bullish flag represents a neat consolidation pattern that occurs in an uptrend. Prices form a neat channel that gradually drifts lower. The pattern is triggered when the price breaks the upper channel with a target the same height as the up move preceding that flag. A stop loss should be placed below the lowest point of the flag. A bearish flag will occur in a downtrend.
Other continuation patterns include:
- Symmetrical triangles
- Ascending triangles and descending triangles
An example of a trading strategy using a chart pattern
The example below is an example of a bullish falling wedge. This pattern occurs when the price moves lower while volatility falls. Eventually, the price becomes oversold and prices move higher just as volatility picks up.
The entry is triggered when the price breaks the upper edge of the wedge. The target is calculated by adding the height of the pattern to the breakout point. If the price breaches the low of the wedge the pattern has failed and any trades could be closed for a loss.
These patterns appear all the time in every market and on every time frame. Future tutorials will cover each pattern in detail along with a strategy to trade each pattern.
Level 6, 360 Collins Street
Risk Warning: Margin trading involves a high level of risk, and may not be suitable for all investors. You should carefully consider your objectives, financial situation, needs and level of experience before entering into any margined transactions with EightCap, and seek independent advice if necessary. Forex and CFDs are highly leveraged products which mean both gains and losses are magnified. You should only trade in these products if you fully understand the risks involved and can afford losses without adversely affecting your lifestyle (including the risk of losing substantially more than your initial investment). A Product Disclosure Statement (PDS) and a Financial Services Guide (FSG) for our products are available to download from our Legal Documentation page. You must assess and consider them carefully before making any decision about using our products or services.
EightCap is a registered business name of EightCap Pty Ltd (ABN 73 139 495 944). We are regulated by the Australian Securities & Investments Commission (ASIC) - our AFSL number is 391441. This licence authorises us to provide financial services to people in Australia.
The information on this website is of a general nature only and is not directed at residents in any country or jurisdiction where such distribution or use would be contrary to local law or regulation. EightCap is not a financial adviser, and does not issue advice, recommendations, or opinion in relation to acquiring, holding or disposing of a margined transaction. We provide general advice only and accordingly you should consider how appropriate the advice (if any) is to your objectives, financial situation and needs before acting on the advice.